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Tuesday, June 7, 2011

Vanguard’s Move to Canada Encouraging but Initially Disappointing

Vanguard has made a formal announcement that they will be entering the Canadian investment market, but here are few details yet on what ETF or mutual fund products will be available.

This announcement is initially disappointing because “Vanguard’s initial focus in Canada will be to offer investment products to Canadian investors through investment advisors.” While some investors prefer to get advice from an investment advisor, many of us prefer to save the added cost and make our own choices. Vanguard’s offerings are unlikely to be of much interest to me until I can purchase ETFs directly on a stock exchange.

On the other hand, Vanguard’s U.S. products have been so beneficial to American investors that the prospect of having them do the same for Canada is very exciting. If I were an American, I would likely have all my long-term savings invested in a small number of Vanguard broad index ETFs.

Canadians can buy the American version of these ETFs, but this creates two potential problems: currency conversion costs and U.S. estate taxes. It is challenging for Canadians to invest in ETFs that are bought and sold in U.S. dollars without paying unreasonable fees for converting between U.S. and Canadian dollars. Knowledgeable investors can usually avoid the bulk of such costs with some inconvenience, but many investors simply pay the high currency-conversion costs.

Thoughtful readers might observe that currency conversion is inevitable when buying U.S. equities. If a U.S. stock ETF is bought and sold in Canadian dollars, then a conversion is needed before the fund buys U.S. stocks. However, Vanguard is much more able to convert currencies cheaply than I am.

Note that this currency conversion problem is unrelated to the currency hedging that is done in many ETFs that hold foreign investments. I won’t be interested in any Vanguard products that include currency hedging.

The second problem of U.S. estate taxes applies the larger portfolios. Beyond a certain threshold portfolio size, your estate may have to pay taxes in the U.S. The rules for U.S. estate taxes have changed a few times over the last couple of decades and it’s difficult to predict what will happen in the future. It’s also difficult for me to predict when I’ll die and how much money my estate will have. This makes planning for estate taxes tricky.

I’d be thrilled to have Vanguard bring their investor-friendly products to Canada in a way that do-it-yourself investors can buy directly. Hopefully, they will offer products that minimize currency conversion costs and minimize the likelihood of getting ensnared by U.S. estate taxes. An additional hope is that Vanguard will eventually make it possible for Canadian investors to invest in foreign assets much more cheaply than they can right now.

Even if Vanguard does introduce Canadian-listed ETFs, there is one reason to continue to hold US ETFs directly in their RRSPs because we can avoid the withholding tax on US dividends. At a dividend yield of 2%, the US ETF will be cheaper by 0.3% p.a. in a RRSP account.

@CC: Good point. This seems like a tricky problem for Vanguard to solve. I'm guessing that they'd be motivated to find a solution if possible, but they may not be able to do so. Perhaps the only answer would be an index mutual fund (i.e., non-ETF) where Vanguard registers the accounts as RRSP accounts to avoid the withholding.

Unless they have some innovative products up their sleeve, we'll end up with versions of the TD index funds - only more widely accessible through advisors initially and slightly cheaper through brokers later.

TD obviously makes a lot of money off the funds especially by creating scarcity and having to open an account there.

Michael, the new head of Vanguard Canada has stated that Vanguard doesn't pay commissions (which is true in the US). It sounds to me like any products they offer will be accessible to everyone, but they want to work with advisors too.

Without commissions, fee-only & wealth management advisors will be the only advisors using their products.

In the US, you can set up a self-directed account directly with Vanguard. My assumption is that model will be used here too. Plus they will work with advisors (non-commissioned) as well.